Shares Green Mountain Coffee Roasters (GMCR) have been in free-fall over the last year, with shares down 80%. The once high-flier is facing multiple questions about its ability to respond to competitive threats and to address its upcoming patent expiry. We feel Green Mountain provides an adequate risk-reward at its current price, as these unknowns are well-understood and reflected in the share price.
Balance Sheet Unclogged
In March 2012, we wrote that Green Mountain was a good short after Starbucks (SBUX) announced it plans to enter the home-brewing market. Green Mountain shares have fallen some 50% from that writing. The reason was clear: despite its strong sales growth, Green Mountain was not profitable from a cash flow perspective. Since GAAP earnings are relatively easy to manage, it is always important to get a confirmatory signal from free cash flow.
From 2009 to 2011, sales at Green Mountain grew from $786 Million to $2.6 Billion, while free cash flow decreased from -$10 Million to -$283 Million. Similar to Gillette, Green Mountain sells the "razor" (Keurig machine) at cost and then its proprietary "razor blade" (K-cup) replacements at a premium. Such models are normally cash flow positive shortly after product launch. The negative free cash flow was a clear red flag that there were clogs in the system.
Green Mountain has taken steps -- admittedly under intense investor prodding -- to improve its working capital and capital expenditure investments. In June 2012, Green Mountain reported a positive free cash flow of $43 Million, its first year of cash flow profitability since 2009.
Given its profitability, Green Mountain is an interesting play at its current P/E of 10. Since expectations are quite low on the stock, a decent earnings report will likely ignite the shares. Green Mountain needs only to demonstrate stabilization rather than growth.
At this price, investors are receiving the company's future earnings growth at a substantial discount. Yes, Green Mountain has competitive headwinds on the horizon. But, the current valuation is warranted only if one assumes that Green Mountain's clock get cleaned: customers defect to Kroger's (KR) and Starbucks en masse, or that generic K-cups crowd out Green Mountain's offerings. While this scenario is possible, that potential is adequately priced into the shares.
While Green Mountain trades on headlines of Starbucks' latest moves, investors can purchase shares of a company that is generating substantial cash flow from its operations. Yes, Starbucks has a good product, but Green Mountain has enough loyal customers to provide it a stable earnings stream. At a P/E of 10, investors get an established brand at a reasonable price that provides good risk-reward.